If your S corporation has excess cash, it may be tempting to take some of it out in the form of a shareholder loan, but consider the consequences before you do it. Borrowing from your sole-owner S corporation has no advantages, and, in some circumstances, it could trigger taxable capital gains for you. Even if you execute a formal interest-bearing loan document with a repayment schedule, it may not stand up to IRS scrutiny.
A Loan to the Sole Shareholder Re-characterized as a Distribution
Because an S corporation is a "pass-through entity," any loan interest you personally pay the S corporation would be offset by the interest income of the corporation. The additional income would come right back to you, canceling out the interest-expense deduction on your personal tax return. In other words, it would become an interest-free loan and would be re-characterized as a distribution. Such a transaction would lower your basis in the S corporation, but would have no tax consequences unless you borrowed more than your basis in the corporation.
Your basis is the amount you paid to buy stock, plus your share of net income and any additional investments or loans you have made to the S corporation, less your share of net losses and any distributions you have received. You are required to run this calculation each year and attach a basis worksheet to each year's S corporation federal tax return.
Tax Consequences of a Distribution in Excess of Basis
In an S corporation, your basis can never fall below zero. If you take out more money than your basis allows, the excess over basis becomes capital gains income on your personal tax return. For example, if your basis in the S corporation is $9,000 and you "borrow" $10,000, the excess is $1,000. The $9,000 is characterized as a distribution, bringing your basis to zero. The additional $1,000 is deemed capital gains income taxed at the current capital gains tax rate.
Consequences of a Zero Basis
A zero basis prevents you from taking any losses generated by the S corporation. The loss is suspended and carries into future years until your basis is sufficiently restored. One way to restore basis is for the S corporation to make profits in subsequent years without your taking any distributions until your basis goes back up. Then the suspended loss will be available -- to the extent of the restored basis -- to file on your personal tax return.
Restoring Basis Through a Loan to the S Corporation
A faster way to restore basis is to make a loan directly to your S corporation. Your basis will rise to the extent of the loan. For example, if you have $5,000 in suspended losses, loaning the S corporation $5,000 with a properly executed loan document approved by the board and recorded in the corporate minutes, will allow you to take $5,000 of suspended losses against income on your personal tax return. However, these convoluted transactions are rarely worth the additional effort and inconvenience involved in trying to take a loan from your S corporation.
- Transfer of money from hands in hands image by Irina smolina from Fotolia.com